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Bond ETFs – Where is the Income?

Here is a list of the top 25 Fixed Income ETFs in the US by AUM. Excluded from this list are High Yield Bond ETFs, International Bond ETFs, Active ETFs, Leveraged and Inverse ETFs. I believe this is representative list of the standard fixed income market of the traditional bond purchaser and represents $157 billion in assets.

What is the Net Yield?

So what information can we take from this data set? First, the average stated yield, or current yield (the number on Yahoo finance and the fact sheets) is 2.44%. Traditional bond buyers are not concerned with current yield (CY) but rather the yield to maturity (YTM), which is 1.88% in this data set and 23.10% less than the CY. Additionally, the fixed income world remains somewhat opaque and therefore the average premium investors pay (cost of ETFs exceeding the underlying value of the bonds) to purchase these ETFs is about 0.20%, which further reduces the net yield to 1.67% or 31.43% off the CY. Then we need to consider the average expense ratio of 0.18% which gets us to a best-case scenario of 1.49% net yield or 38.93% less than the current yield of 2.44% that is prominently displayed in the advertising.

And, this is before trading costs, such as commissions and advisory fees, and inflation adjustments (Note: if inflation expectations don’t increase the real net yield on Shares Barclays TIPS Bond ETF is actually -0.97%). And for one last comparison, let’s look at the current yield of 2.44% and subtract the average discount (0.20%) and average expense ratio (0.18%) to get a net current yield of 2.06% and compare it to the current yield of SPY (the S&P 500 Index ETF from State Street Global Advisors) at 2.07%, and the income produced by fixed income ETFs looks pretty bleak.

The Income Barbell Portfolio

The fact that Bond ETFs do not currently offer sufficient yield requires flexible and innovative ways to find reliable sources of income in disparate markets. One of the techniques to use to meet the challenges of this “yield drought” is to build an “Income Barbell Portfolio”. This structured approach combines unequal weightings of cash and income-oriented investments to synthetically construct a higher yielding portfolio than investors can find with traditional income investments like bonds or open-end bond funds.

Traditionally, when pursuing a bond barbell strategy, you buy short- and long-term bonds only. Theoretically, this provides the best of both worlds. At the high end of the barbell, you lock in higher rates. On the short end of the barbell, investors have less interest rate and credit risk. And when short-term bonds mature, investors use their proceeds to reinvest.

Investors often use bond barbell portfolios during periods of rising interest rates or when the prospect of higher rates is imminent. By investing in the extremes of the income hierarchy, investors have the potential to increase their portfolio’s overall return while the short end gives an extra margin of safety against credit defaults and interest rate risk.

However, an Income Barbell Portfolio expands the potential universe of income-oriented investments. One of the more sophisticated ways to construct the risk end of the Income Barbell is to combine unequal weightings of Exchange Traded Products (ETPs), closed-end funds, preferred stocks, dividend producing common stocks, REITs and income-oriented MLPs. Place an emphasis on safety and liquidity at one end of the barbell buying cash equivalents and stretch the envelope at the other end by investing in higher yielding, riskier income-producing assets.

One of the biggest champions of the “barbell strategy” is Nassim Taleb, the author of The Black Swan. Taleb believes that all investors are vulnerable to prediction errors –black swans — and that most Modern Portfolio Theory (MPT) risk measurement metrics are fatally flawed. Asset returns are more diversified on the upside and considerably less on the downside — precisely the opposite of what most investors desire particularly when financial turbulence strikes.

Nassim Taleb believes investors should be “hyper-conservative” with most of their monies and “hyper-aggressive” with a small portion of their portfolios instead of putting their money in “medium risk” investments.[1] You put the lion’s share of investable funds in extremely defensive assets and the remainder in more speculative income-yielding assets. High cash reserves and very liquid, short-end maturities on one end coupled with plenty of small bets in the aggressive end of the barbell strategy.

In summary, there are several higher yielding income products that investors can use to cope with a historic Yield Drought. It’s in tough times like the present, that competent and caring financial advisors genuinely earn their keep.

[1] Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, NY 2007, pp.205-06


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